REPLACEMENT REVERSAL

Just when the sell side warms up to the idea of a recovery, Q4 replacement sales are likely to disappoint.

The sell side finally seems to be on the replacement recovery bandwagon, even though the bandwagon has been moving forward for a number of consecutive quarters and years. BYI and IGT put up solid September quarters and the stocks took off. The sell side followed up with enthusiasm about replacement demand returning and all is well. Or not.

We hate to rain on the parade but calendar Q4 replacements are likely to fall sequentially and, yikes, YoY. IGT could see the biggest drop since they appeared to pull sales forward into the September quarter. A significant market share decline in CYQ4 may be disappointing, considering IGT's long thesis of “continued share gains”.

BYI should still gain share in CYQ4 and we continue to believe they are the best positioned supplier over the intermediate and long-term (trend and tail). However, this stock has been a rocket ship since our positive call during G2E. A disappointing industry wide replacement quarter will likely not be a positive for the stock with maybe the most bullish sentiment.

At this juncture, we think both IGT and BYI can make consensus estimates but the quality would be low and transparent. IGT does a better job of managing earnings – lower than expected revenues, higher margins and vice versa – so it may be a little safer from an earnings perspective but the market share drop would hurt. WMS is likely to miss in our opinion but we can’t believe there are still people out there who think WMS is going to have a decent quarter any time soon.

So why do we think replacements will fall in CYQ4?

IGT which had a 40% share of replacements last quarter at 5,100 is likely to see about a 1,500 sequential drop in replacements – partly due to seasonality and partly due to what we believe was pulling forward of demand. September is IGT’s fiscal year end, so that quarter tends to be their best.

WMS should be up sequentially but definitely still down YoY so they won’t be making up the difference. WMS also appeared to pull forward some units into the September quarter.

We believe that with all the uncertainty in 2010, there was some flushing of capital budgets in the December quarter

Bottom line, we think that there will be a modest YoY decline between 1-5% in replacement demand – the first YoY decline since 3Q of calendar 2010.

We still think 2012 will be a good year for the slot suppliers: resumption of replacement demand growth, huge growth in slot sales to new and expanded casinos, and a more visible and growing systems business (mostly BYI). But we may have to take a step back this quarter to move forward. However, we’re not sure the Street is ready for the step back just yet.

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